Barron’s | Finally, A Rally Begins! But its Stamina is the Big Question

Stocks soared 6% last week on relatively low trading volumes, as continued short-covering helped the market put together two consecutive up weeks for the first time since early July.

Though the rally is young yet, already some participants doubt its longevity, given that much of the activity appears to be computer-driven momentum-buying and short-covering, not some Niagara of traditional buy orders. Moreover, while third-quarter earnings reports came in as expected, the sovereign-debt situation in Europe could deteriorate in a heartbeat. Consequently, many institutions remain on the sidelines, traders say.

Nevertheless, no one will reject a rally after the past 10 weeks of troubles. The Dow Jones Industrial Average closed at 11,644.49, up 5% from the previous Friday. The Standard & Poor’s 500 jumped 6% to 1224.58. The Nasdaq Composite finished at 2668, ahead some 8% on the week,

The fact that the market moved so much on less-than-strong volume and on little in the way of real positive news gives rise to skepticism, traders say. Christopher Zook, chief investment officer of CAZ Investments in Houston, concurs: “It’s not like the European situation has been solved. It’s feeling like a bear trap.”

For the week, the economic news was mildly positive. Friday, the Commerce Department said September retail sales rose 1.1%, above consensus, with auto sales strong. However, the Thomson Reuters/University of Michigan’s preliminary October read on the consumer-sentiment index fell to 57.5 from 59.4 in September, below expectations.

One interesting snippetcomes from Jeff Smisek, CEO of the largest U.S. airline, United Continental Holdings (ticker: UAL). He said Wednesday that he didn’t see signs of an imminent recession in bookings and business travel. Airlines are the economy’s litmus paper, so that speaks volumes, at least about the next few months.

In the way of earnings, less than two score of the Standard & Poor’s 500 index firms have reported third-quarter numbers so far, and they generally met expectations, with Google(GOOG) showing strong earnings and JPMorgan Chase (JPM) not.

The S&P 500 did move above its 50-day moving average, and “the tone of the tape” has improved, according to Mike Hurley, a portfolio manager of the Highland Trend Following Fund. Still, financial stocks continue to struggle, and that remains a long-term concern for the durability of this rally, he adds.

YOU DON’T NEED TO LOOK AT NEWS footage of the Wall Street protests to know that banks are among the most hated of sectors. In the U.S., the S&P 500 financials index is the worst performer of the year, down 21%. The Stoxx European banks index is only the second-worst in Europe, but it is down a heftier 30% in local currencies. Yet, for those willing to consider financial institutions with a low profile, there are big, well-run, conservatively managed banks that can give investors a quality entree into a despised sector.

Bank of Nova Scotia (BNS), Canada’s third-largest bank by assets, is a sleeper and doesn’t get the respect it deserves, particularly when the market has put the kibosh on all big banks.

With investors petrified of a potential banking crisis in Europe spilling over into the U.S., shares of Scotiabank, as it is dubbed, have fallen to $51.63 from a high of $62.33 this year. Besides the macroeconomic worries, some worry that the Canadian economy is slowing more than expected.

Still, Scotiabank has just 10% revenue exposure to the U.S. and 5% to Europe, notes Matt McCormick, a money manager at Bahl & Gaynor and a longtime BNS bull who calls the drop an overreaction. The Canadian housing market, thanks to a different regulatory regime, never suffered from foreclosure woes. This bank doesn’t have the loan-loss risk U.S. banks do, and an economic slowdown north of the border seems manageable.

With a conservative way of doing business and a 4% stock-dividend yield, “it’s a safer way of playing financials,” notes McCormick. “This is a bank that counts its paper clips,” and Bahl & Gaynor has continued to buy shares into the downdraft, he adds.

The hidden gem, however, is that Bank of Nova Scotia has had a long and profitable history in emerging markets, with Caribbean and South American income—almost a third of the total—helping to juice growth. More recently the bank has just begun putting a toe in China and Vietnam. It has a long track record of establishing small chunks initially, and then expanding successfully in emerging markets, says McCormick. “If they were going to the U.S., that would be suspect,” he adds.

Recent results show Scotiabank keeps chugging along. In the nine months ended July 31, profit rose to four billion Canadian dollars (US$3.96 billion), or C$3.55 a share, from C$3.2 billion, or C$2.91 a share. Its four main businesses—Canadian banking, international banking, global wealth management and the Scotia Capital investment bank—all contributed nicely. Loan-loss provisions dropped to C$774 million, down from C$985 million a year earlier.

BNS sports a return on equity of about 18% and a Tier 1 ratio of over 12%. The 2012 price/earnings ratio of 10.7 times C$4.82 is below its median P/E of 12.3.

The bank has a strong geographic economic base and a better yield, and is relatively more insulated from investors’ bank fears. A total return of 10% in the next year is a conservative expectation, says McCormick, who adds, “It’s a short-term trade for a long-term holding.”

PUBLICLY TRADED COMPANIES generally face two choices with excess cash levels: Pay out through dividends, which are double-taxed, or through the more tax-efficient method of buying their own shares in the market, thereby increasing the company’s value to remaining shareholders…